Diversify into international stocks, warns BlackRock’s Koesterich

Behind the Selloff: EM Issues, Stretched Valuations and Mediocre EarningsSome issues coming from emerging markets helped contribute to the broader decline in stocks last week. China reported some surprisingly weak economic data, and financial turmoil in Argentina and Turkey led to a selloff in EM currencies.

While that volatility was a factor, we believe the decline in US stocks also can be attributed to issues closer to home. We have discussed previously that last year’s gains were powered primarily by multiple expansion, meaning prices were rising faster than underlying corporate earnings. In fact, 2013 saw the largest single-year increase in market valuations since 1998. As stocks grew more expensive over the last year, bonds became less so. As a result, we have been seeing some investors (notably large institutional investors) shifting more assets into bonds over the past few weeks. This helps explain why bond yields have been declining since the start of the year.

On a related point, corporate earnings so far have been less than stellar for the current reporting cycle. Last year’s rally was, to a large extent, based on an act of faith that the economy and corporate earnings would improve, which would, in turn, justify higher stock prices. While the economy does appear to be mending, improvements are modest and so far are not evident in corporate earnings reports.

It is still relatively early in the fourth-quarter reporting season, and to date, the results have been respectable, but hardly inspiring. The percentage of companies that are reporting better-than-expected results is actually below the four-year average, which appears to be frustrating investors. We’re seeing this frustration in the form of fund flows: US equity funds have been seeing outflows, while European and global equity funds have been attracting assets.

Expect Higher Levels of Volatility; Diversify InternationallyMarket volatility in 2013 was unusually low, thanks in large part to the Federal Reserve’s extraordinary monetary policies. As the central bank begins its tapering process and is starting to move away from its ultra-easy approach to policy, we expect market volatility to climb to levels that are closer to long-term averages. While we still think stocks will post gains this year, those gains will be accompanied by more ups and downs.

In this environment, we’ll echo an investment recommendation we have been making for some time: Diversify into international stocks. We’ll point out that during a week where most of the news was negative, Europe surprised to the upside with a surge in manufacturing data. For those investors who have been overly focused on US stocks, we would suggest increasing exposures to international equities- specifically to the other large developed markets of Europe and Japan. In fact, we would recommend overweight positions to both of those regions.